NY futures continued to push higher this week, as July gained 257 points to close at 79.11 cents.

The expiring May contract has rallied nearly 700 points over the last eight sessions, as procrastinators on the short side were forced to pay dearly for their way out. Not only did May close at a contract high today, but the entire board has inverted this week, all the way out to the March contract. As recently as April 10 the May contract had traded at more than 200 points carry to July and now it is at a 100-point inversion!

This price action serves as a warning shot to the many trade shorts that remain in the July contract. Open interest in July was at 12.81 million bales this morning, which is the highest number ever at this date. Only the 2007/08-season comes close with 12.71 million bales. About a third of this open interest is tied to unfixed on-call sales, which still amounted to 4.27 million bales on July at the end of last week.

The big question is whether the trade can once again count on speculators to provide the necessary sell-side liquidity for an orderly liquidation. Trade shorts got lucky last month when speculators liquidated close to 5 million bales net, which equated to a ‘Get Out of Jail Free’ card. But as we discussed last week, this spec flush out and accompanying price break may have led to complacency among traders and they are now finding themselves once again at the mercy of spec longs.

The latest Commitment of Traders report showed specs at 8.4 million bales net long as of April 11, down from a record high of 12.1 million bales in March, but there has been additional spec long liquidation in the two sessions leading up to the Easter break. We therefore estimate that specs were down to around 7.0-7.5 million bales net long at the beginning of this week.

While some analysts feel that speculators will continue to get out of cotton, the strong showing of the market this week may actually convince them to take another look at the long side. With the 14-month uptrend still in force, with May closing at a contract high and with an inverted board, it seems more likely that specs would either hold on or add to their longs than get out.

US export sales once again beat most expectations as they amounted to a combined 355,300 running bales of Upland and Pima cotton for both marketing years combined. Participation continued strong with 17 markets buying and 21 destinations receiving shipments of 367,200 running bales. For the current season commitments have now reached 14.15 million statistical bales, of which 9.9 million bales have so far been exported. Sales for August onwards are at 2.25 million statistical bales.

We believe that there are now less than a million bales remaining for sale in the US, including the certified stock of around 300,000 bales. Export sales are therefore going to drop to a trickle over the coming weeks and expectations need to be lowered accordingly.

So where do we go from here? The fireworks in the May contract are probably over, since we started the day with just 6,030 contracts open and there were an estimated 5,660 Mays traded today. In other words there won’t be a lot left to liquidate! It also looks like the certified stock, or at least most of it, won’t change hands during the upcoming notice period.

The significance of this last moment flare up in May is that it serves as a wake-up call for the many July shorts that remain. The way we see there are two possible outcomes over the next two months.

The first scenario would follow the script from last month, whereby speculators simply continue to abandon their net long position and thereby allow trade shorts to escape without any harm. Why would speculators get out of cotton given the constructive technical picture? Their motivation may come from outside markets or events, be it a weakening economy or a geo-political event (North Korea, Iran), which could prompt them to move to a “risk off” position.

In the second scenario speculators would continue to hold on to their long and even add more to it, which would further fuel a market that is already moving higher on trade short-covering. In such a scenario there is no telling how high the market might spike. Recent history (2008 and 2011) has shown what can happen when there isn’t enough sell-side liquidity!

We would give these two scenarios about equal odds at the moment. Even though the set-up for a short-squeeze is in place, weakness in the commodity complex and the economy, as well as expectations for a sizeable increase in plantings all over the globe are starting to weigh on traders’ minds.

Given the near sold out situation of US cotton it will be the specs that decide where the market is headed next, but even if they were to get out of longs July would likely remain above 74/75 cents for the remainder of its contract life. On the other hand if specs were to force the issue, July could easily spike another 5-10 cents from current levels.

New crop would follow July up to a certain degree only and we would therefore advise growers to aggressively buy bearish options strategies in March if it were to move into the 75-77 cents window.

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